Ukraine and Bonds

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We have been closely following the conflict in Ukraine. While the situation is evolving rapidly, it appears for the moment that Russia remains steadfast in their desire to prosecute this ill-advised offensive while Ukraine remains steadfast in their desire to defend their country. If recent decades of history are any guide, the Russians will be unsuccessful attempting a long-term occupation, but in the meantime, they can inflict a great deal of damage. 

We won’t solve the world’s geopolitical problems here, but what we can do is use this as a lesson in understanding our approach to our own financial risk tolerance and investments. Our letter to clients last week on the Ukraine situation received a lot of feedback, so here we would like to reiterate and elaborate on one of the points we made regarding bonds.

Bonds are getting a lot of negative press these days, and some of that negative press is rightfully earned. Bond yields are as low as they’ve been at any time, going back at least to the early 1960s. More importantly, given the relatively high inflation we’re experiencing, most bonds are currently experiencing negative real returns. This means that the purchasing power of money invested in bonds could decline, at least slightly, as time goes on.

So why in the world would somebody own bonds? The answer is that 100% of every investment portfolio in the world has to be invested—in something. Most people should not—or cannot—invest their portfolio 100% in stocks, even if stocks are likely to beat bonds (and most other asset classes) in the long run. Even if an investor does have an iron constitution and can handle the volatility of an all-equity portfolio, there can still be problems around retirement known as sequence of returns risk, where a big stock drawdown can mean investors must sell their equities while markets are depressed. This can impair retirement plans even if the market has an attractive return over the full retirement period.

Every dollar not invested in stocks has to go somewhere else. You can’t just stick money in cash and say it’s “off the table,” that capital is still acting as a drag on your portfolio in most markets and therefore must be included in your returns. Diversifiers such as real estate, gold, or other commodities may be part of the answer, but they are likely to have no real return greater than inflation in the long run. 

Even today, bonds are not hopeless. Bonds can perform entirely adequately in environments of rising interest rates and bond yields, such as the period from 1962-1982. The performance is not stellar, but bonds do what they need to do, which is mitigate the volatility of equities, especially in big equity drawdowns. 

When you watched the news of invasion in Ukraine last week, did you worry about your stock portfolio? Did you wish you had more bonds in your portfolio? Did you even momentarily think about going to all cash? If so, then you should seriously consider a little more defense (aka more bonds) in your portfolio. The time you need to decide on a less risky portfolio is before the bad news comes out, not after. Bonds have an important portfolio role in bad times, which is why it’s a good idea to get them in place in good times. If the conflict in Ukraine has you feeling uneasy, now is good to talk to your advisor about whether your need, desire, and ability for risk can accommodate a more defensive allocation in your portfolio going forward. It’s much better to have a little bit more fixed income in your portfolio now rather than panicking and selling everything when markets look scary!


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